The Pros and Cons of MLPs

Most stocks are fundamentally the same kind of investment: they’re shares of ownership in a corporation. There are a few exceptions, however. One is “Master Limited Partnerships” (MLPs), which are popular among many investors because they tend to have very high yields. MLPs trade on stock exchanges just like other stocks, but there are important differences from both a legal perspective and an investment perspective.

MLPs are mostly energy companies, such as companies that operate the pipelines that transport oil and gas across the US. They’re technically “partnerships” rather than “corporations” so their profits can go straight to their shareholders without being taxed at the company level. As a result of the tax laws related to this difference, MLPs distribute a large portion of their profits to shareholders, making them very high-yielding investments. They also have additional tax advantages: for example, a large portion of the distributions are usually taxed when you sell the investment rather than immediately when the distributions are paid.

Of course there are plenty of drawbacks to MLPs as well. Since MLPs are generally energy companies, having too much exposure to them can make your portfolio vulnerable to a downturn in the energy sector. Furthermore, since MLPs distribute almost all of their profits to shareholders, they regularly need to raise new money to maintain and grow their business. This can make them sensitive to problems in financial markets: many MLPs struggled to raise funds at attractive rates during the financial crisis.

In sum, MLPs can be an effective way for investors to generate income from their investment portfolio and get some tax benefits to boot. But like most types of investments, having too much exposure to MLPs can create substantial risks.